Uncovering the Monetary Policy Rule in India

India’s central bank, the Reserve Bank of India (RBI), has an unenviable task. It is not really independent, it has multiple objectives (not all of its own making), it has to deal with a country that is extremely heterogeneous in terms of economic structures and development levels, and it often lacks good data for its decision-making. In the circumstances, one might agree with senior RBI officials who argue that it does a good job under the circumstances, especially in helping to keep India’s financial house in order and externally-generated crises at bay. Others, outside the RBI, have pressed for greater simplicity, transparency and predictability in the RBI’s functioning.

“Some observers have suggested that the Reserve Bank of India (RBI) should also adopt an inflation targeting arrangement. Most recently, the Raghuram Rajan report of the Committee on Financial Sector Reforms (CFSR) made the following recommendation: ‘The RBI should formally have a single objective, to stay close to a low inflation number, or within a range, in the medium term, and move steadily to a single instrument, the short term interest rate (repo and reverse repo) to achieve it.’ This in turn has fuelled a great deal of debate, particularly at a time when prices in India have been rising at an accelerating rate (despite increased fuel and food subsidies to cushion the impact of commodity price rises, inflation based on the Wholesale Price Index (WPI) exceeded 8 percent in the first half of 2008).

“Critics have argued that the RBI’s monetary policy in recent times has been inconsistent and, thus, a source of some confusion to observers and market participants. More specifically, the RBI remains very elusive as to what is being targeted and how the target is being attained. Rather, the RBI’s monetary policy framework has been based on a rather ad hoc combination of sterilized foreign exchange intervention (via Monetary Stabilisation Scheme (MSS) bonds), interest rate changes along with nonmarket mechanism (hikes in the cash reserve ratio (CRR), ad hoc capital controls etc).”

Recently, the RBI has been worrying about inflation. CPI inflation has been stubbornly high, especially because of food price increases. Even when the WPI was falling last year, the RBI seemed to be slow to loosen monetary policy in the wake of the global economic crisis, because of high CPI inflation. They also seemed to be using year-on-year WPI inflation, which was far too backward looking. Now, when the WPI is falling measured year-on-year, the RBI seems to be focusing on more recent rises in the WPI (the last few months). If this is correct (as the quote above indicates, one cannot be sure of the RBI’s exact policy framework), then there seems to be an asymmetry in the RBI’s responses to slowing growth and to inflation threats.

This example would suggest that the RBI is an inflation hawk, and less concerned with output growth. However, Michael Hutchison, Rajeswari Sengupta and I have been estimating Taylor-type monetary policy rules for India, and we tend to find that the RBI is not very hawkish on inflation, but more sensitive to the output gap (some definite results on this coming soon – I’ll announce them when we’re done). We will also have some indication of the RBI’s responses to CPI vs. WPI inflation. Our analysis will cover the 1980-2008 period, and so allows us to look at changes in the implicit monetary policy rule over time. I say implicit, because as noted in the quote above, the RBI looks at “everything” and has no public or private rule that it follows. We are trying to estimate the “revealed rule” of the RBI. Since an optimal Taylor rule comes from some underlying loss function, this is a “revealed preference” approach to understanding what the RBI does.

Vineet Virmani did some work on this a few years ago, but used data only for 1992-2001 – this period covered a lot of changes in policy, so it might be difficult to reach robust conclusions. He found some interesting results, including the role of money supply growth and exchange rate levels in the RBI’s implicit policy rule. Most striking was the sensitivity of his results to the inflation measure used in estimating the rule.

One factor that is cropping up in the RBI’s recent policy statements is concern about the fiscal deficit. India began running up larger fiscal deficits before the crisis, and the crisis just added to the fiscal stimulus. The main driver of fiscal extravagance had been political compulsions to pump money into rural India, through the rural employment guarantee scheme, farm loan repayment waivers, and the like. Just as in the U.S., there is now some concern about the impact of the fiscal deficit on private investment (crowding out) and on inflation. The RBI is looking at 5% inflation and 6% growth down the road, and worrying that the fiscal deficit will stoke inflation. The problem is that it isn’t at all clear that the inflation India is seeing now is driven by demand factors, or by easy credit. The poor monsoon may be a big factor in the current food price surge, which would suggest policies to address domestic supply constraints, rather than monetary tightening. One problem is that no one seems to have a good model of the Indian economy’s responses to supply shocks, monetary policy, or perhaps to anything at all. Policy making is mostly ad hoc. So there’s potentially plenty of work for economists in India, or those studying India.